Wednesday, March 7, 2012

Lombard Street On Computer Models Versus Looking At The Facts

Korzybski said that in a different context but it is so appropriate to modeling of all sorts, climate, finance, economics etc. that I put it up top on almost every modeling post.*
Via ZeroHedge:

This is Part 1 of a series from Lombard Street titled "Last Spin
Of The Wheel For Europe's Banks." As the title indicates, Lombard Street
is hardly bullish on Europe's chances to avoid a fate that was
described earlier by the IIF, only this time instead of just €1 trillion
which would be the cost of a Greek disorderly default, the final tally
will be many orders of magnitude higher and will also drag down the ECB,
and the world with it.Computer models versus looking at the facts
In 1974, Hyman Minsky explained the unfolding of credit cycles with
his Financial Instability Hypothesis. It identifies three types of debt
financing: hedge (borrowers can pay principal and interest from income,
so risk is minimal); speculative (borrowers can pay interest from
income, but need liquid financial markets to refinance the principal at
maturity, so defaults rise when liquidity is impaired); and Ponzi
(borrowers can’t pay either interest or principal out of income, so need
the price of the asset to rise to service their debts and defaults soar
when asset prices stop rising). Confidence rises over a prolonged
period of prosperity, so a capitalist economy moves from hedge finance
dominating its financial structure to increasing domination by
speculative and Ponzi finance.

Financial markets and the economy are relatively stable when hedge
financing dominates, but become ever more unstable as the proportions of
speculative and Ponzi finance rise. The rising instability causes
cycles of increasing severity until fear takes over and financial
markets suffer a self-reinforcing spiral downward. Banks are the core of
the financial system, so Minsky correctly says bank balance sheets
deteriorate until inability to service liabilities causes a ‘Minsky
Moment’ – a debt crisis that forces bloated asset prices down to levels
that are appropriate to the real economy of production and income.

The questionable lending practices and the banking business models
that caused the 2007–08 banking crisis and Great Recession certainly fit
Minsky’s definition of Ponzi finance. That ‘Minsky Moment’ was a major
turning point in global financial and economic history. It began the
correction of all the imbalances that have accrued since the last major
turning point – the huge monetary stimulation in response to the Penn
Central non-bailout in 1970. (It changed the focus of most central banks
from guarding against inflation to protecting banks from everything.)

Many analysts ignore financial debt when computing debt to GDP ratios
– odd because financial debt is always a factor in financial crises.
Financial debt in the US has fallen 20% from its high at the end of
2008, but is up 10% in Europe, shifting the locus of the banking crisis
to Europe, where the quality of sovereign debt has fallen as financial
debt has risen. Moreover, bankers on both sides of the Atlantic are
continuing two serious errors that were major factors causing the last
banking crisis;

putting more reliance on computer models than common sense and

failing to purge their balance sheets of failing assets due to inadequate net tangible equity to absorb the losses.

Contrary to the hype, computer models are very fallible. As predicted
in February 2007, they greatly underestimated financial risk by failing
to incorporate obvious correlations as well as being responsible for
rating securities based on home equity loans and sub-prime mortgages
AAA. Reliance on computer models also explains the failure to spot
turning points. Only external shocks divert models from moving towards
the equilibrium position, so all forecasts tend to be straight lines.
Computer models don’t, and probably never will, identify turning points....MORE

*We have so many posts on models and modeling that it is easiest to just give you the Google search results:

I read a book last year, Useless Arithmetic: Why Environmental Scientists Can't Predict the Future,
that, while a bit light on the 'whys', packs more understanding of
computer modeling into230 pages than you are likely to find anywhere
else.

The author, Orrin H. Pilkey is Emeritus Professor of Geology at Duke.
The first review I'm going to link to appeared in American Scientist.
The reviewer is Carl Wunsch, Carl and Ida Green Professor of Physical
Oceanography in the Department of Earth, Atmospheric and
Planetary Sciences at the Massachusetts Institute of
Technology....

Eventually
the government might be forced to nationalize a large swath of the
banking sector, but they'll be dragged kicking and screaming.
Yesterday's non-bailout announcement aimed to preserve the status quo,
and Obama himself dismissed the idea that the US could adopt the Swedish
model in an interview with ABC...